Thursday, December 8, 2011

Inequality and Taxation

This seems what everyone is focused on - occupiers, partiers, people who want to stay in office, people who want to kick those people out of their offices, etc. Plenty has been written on this, but I'll extract a small sample here in an attempt to sharpen the ideas.

Economists like to think about two kinds of habit - internal and external. With internal habit I care not only about my current consumption, but about my current consumption relative to my past consumption. I'm better off with more current consumption, but more past consumption makes me currently worse off. With preferences like these, I become accustomed to a high standard of living. I'm much happier if I have always been poor than if I am poor today and rich yesterday. Internal habit is used a lot in macroeconomics. You see it in estimated New Keynesian models, for example Christiano/Eichenbaum/Evans, and in work on asset pricing. I think this has more to do with adding free parameters to fit the data than any micro evidence to support the idea, but there you are.

In any case, internal habit is not going to help the arguments of people who want to redistribute income from rich to poor. Internal habit will tend to favor the status quo, as there will be large transition costs in terms of lost welfare from making the rich poorer. Further, if everyone in the economy has preferences with internal habit, I'm not sure what is Pareto efficient, or if anyone has even solved that problem. For all I know, you solve the problem and it looks completely goofy.

Frank is concerned with external habit - envy, essentially. This is an externality, sometimes called "keeping up with the Joneses." I am worse off the better off my neighbor is. In Frankworld the poor are so overcome by envy that we might as well take the wealth of the rich and throw it away. This would make the poor feel immensely better. Something like kicking a banker in the nuts. Conversely, the rich get some of their happiness from having more possessions than the poor, and flaunting all that stuff. Seymour Cray, for example, liked to build a sailboat every year, but apparently did not sail it. Each year, he would burn the old boat to make room for the new one. However, it's not clear we want to think of Seymour Cray as an example of the typical behavior of rich people. His Wikipedia entry tells us:

Another favorite pastime was digging a tunnel under his home; he attributed the secret of his success to "visits by elves" while he worked in the tunnel: "While I'm digging in the tunnel, the elves will often come to me with solutions to my problem."

Frank seems to think that external habit implies that we should all consume the same quantity. Thus, no more envy. Let's explore this idea further. External habit tells us something about the types of neighbors we like to have. Frank says that the best neighbor the richest person in the population could have is the poorest one in the population, as that makes him or her feel really good. But there is a problem, which is that the best neighbor the poorest person can have is the next poorest one. If you let everyone choose their neighbors, what will they do? This problem has actually been solved. Some of Ken Burdett's marriage models with search fit this exactly. The result is that there is positive assortative matching. Like types tend to match - poor with poor and rich with rich. Frank's theory thus explains neighborhood stratification, something which happens everywhere, and with a vengeance in St. Louis. So far, the theory looks pretty good.

However, note that you would also get positive assortative matching if the externality goes the other way. If any individual feels happier the richer their neighbor is, then we get exactly the same outcome, with the same neighborhood stratification. Similarly, suppose in the marriage matching story that every individual prefers a taller partner to a shorter one. Then, there will tend to be matching of tall types with tall types, and short types with short types. But if each individual prefers a short partner to a tall one, you get the same result.

So, which do you think it is? Do I prefer having a rich neighbor or a poor neighbor? If it's the former, and we follow Frank's logic, he has a lot of explaining to do. Given the conclusions he makes in the latter case, in the former case it would be a better society if we made one person enormously rich, with the rest of us living at subsistence.

What does Frank think explains the recent increase in income dispersion in the United States? The received explanation for this is basically "supply, technology, and trade." Changes in technology have changed the relative demands for high-skill and low-skill workers, high-skill workers are scarce because it is very costly to acquire the skills, and low-skill-intensive goods can be produced more cheaply abroad than used to be the case. A small amount of the increase in dispersion in income is due to the US income tax becoming less progressive. But Frank has a different idea. This also has something to do with technology, though.

Frank uses the example of music. Everyone in the world can now hear the best guitar player in the world, without going out of the house. So why should I pay any attention to the second-best guitar player in the world? Ultimately, the best guitar player in the world gets a huge market share, and second best gets close to nothing. Society then consists of a small number of stars getting enormous salaries and the rest of us getting close to nothing. But surely if second-best is willing to work for a little less, I might prefer that. Or seeing #500 guitar player in the local bar for a $5 cover charge could dominate paying $200 to sit in a nosebleed seat in Madison Square Garden to see #1.

What seems to make Frank's argument fall apart is congestion and scale economies. You can see this when he gets to his other examples. Frank wants to think of his university president, David Skorton, as one of these superstars. First, contrary to what Frank seems to think, my guess is that Skorton earns something in the range $500K-$600K. An odd characteristic of the market for university presidents is that the high-paid ones are mostly at schools you have never heard of. There may be a theory that explains that, but I don't think it's the one Frank has in mind. Second, Skorton was my university president once as well. People at the University of Iowa thought of Skorton as a good guy, but I don't recall the word "superstar" floating around.

Frank wants to dismiss corporate governance explanations for high executive compensation, but I'm not sure he's right. Small differences in the ability of a CEO may indeed make huge differences in corporate outcomes, but it's very difficult for a Board to discern those differences. How do you tell a good one from a bad one? Thus, you can't rely on those small differences to explain huge differences in compensation.

Finally, Frank gives us his solution to inequality, which is a progressive consumption tax. A consumption tax is sometimes thought to have some virtues relative to the income tax as a means for generating revenue, but as typically envisioned, it would also be less progressive than the income tax. Replace the current federal income tax with flat-rate value-added tax generating the same revenue (I'm neglecting the issue of deductions), and income dispersion will increase.

The problem is that, if the consumption tax is collected at the point of sale, it has to be a proportional tax. We can't have retailers checking their customers' total consumption, and even if they could there would be ways to game the system. Frank's suggestion is that consumers report their incomes and net asset positions, from which we can determine individual consumption, which we then tax progressively.

Frank thinks that a progressive consumption tax will cure all our problems. Frankly, I don't see it. First, Frank has not thought through the tax evasion problem. How easy would it be to cheat in this system, relative to the current one? The cheating one would want to do is to under-report income and over-report asset accumulation. The income under-reporting problem is one that exists currently, so that is no different. However, over-reporting of assets is something new altogether. One could imagine that over-reporting could be quite easy. This might amount to shady appraisals or asset valuation that could be very difficult to check.

Second, even if you can solve the evasion problem, what do you gain relative to a progressive income tax? With a progressive consumption tax, individuals have a greater motive for consumption smoothing over time. This works like an increase in risk aversion - not clear this is a good thing. Also, the consumption tax does not actually promote savings relative to the income tax, except because people are effectively more risk averse and will self-insure by saving more. Again, this is hardly a good thing. Otherwise, saving is just postponed consumption. If my current consumption is taxed and my future consumption is taxed, that's a wash in terms of the effect on savings. Indeed, ultimately the distortion shows up in labor supply.

Next, some people have shown interest in this paper by Diamond and Saez. A key result that seemed to get these people excited is the calculation of a top optimal marginal tax rate (including all taxes) of 73%, relative to the current rate of 42.5%. There are two key assumptions that Diamond and Saez make to come up with the 73% optimal rate. First, we should not care about the welfare (at the margin) of the rich people. This argument is based solely on the notion that marginal utility of income is low for the top income-earners. Second, Diamond and Saez use a "behavioral elasticity" of tax revenue with respect to the tax rate of 0.25. To see how this matters, if you use their formula and an elasticity of one, you get an optimal top tax rate of 40%.

Now, I know it is fashionable to dump on rich people, but I'm not sure we want to discount their welfare as much as Diamond and Saez want to. Preferences will matter here. For example, if we take internal habit persistence seriously, as some people like to, that could make us want to weight the rich and poor equally, by Diamond and Saez's logic. I'm not committed to habit persistence, but there may be some features of behavior that are not consistent with log utility, for example. Further, Diamond and Saez are thinking in static terms. In reality, there is mobility within the income distribution, and how much mobility is an important issue here. Given mobility within the income distribution, we all care, for selfish reasons, about how the rich are treated, as we all could be rich some day, or our descendants could be rich.

Finally, I have no idea where that "behavioral elasticity" is coming from, and I don't trust it. My best guess is that it includes none of the factors that I think are important in addressing the problem. What we need here is a dynamic general equilibrium model that can take account of the short run and long run effects of a change in the income tax schedule. My best guess is that "behavioral elasticity" means that Diamond and Saez are measuring the effects of tax evasion and the intensive margin of labor supply, and that's all. If so, I think they miss most of what is important:

1. There's also an extensive margin. Tax people at a higher rate, and some drop out of the labor force.2. Taxes affect occupational choice. Some work by Manuelli/Seshadri/Shin says that the effect of taxes on human capital is big time. Why do I want to undertake a costly and risky investment for a very small payoff?3. Entepreneurial activity has to be very elastic with respect to tax rates at the top end. Why would I want to risk my own wealth or that of my close family for a very big payoff with very low probability, if that big payoff is taxed at 73%?4. The United States is highly dependent on highly-skilled labor that migrates here from other countries. With a top tax rate of 73%, the Indian engineers might prefer to work in India, and the Canadian professors might prefer Canada.

Thus, I think it is likely that tax revenue is much more elastic with respect to the tax rate, particularly in the long run, than Diamond and Saez are letting on. To evaluate this properly, you need a serious model, and they have not provided one.

51 comments:

I was baffled at the elasticity assumptions in Saez/Diamond as well. It's one thing to mention that a huge body of literature believes the elasticity to be higher, then mention briefly mention why you think that is wrong and why you're using a different assumption... it's another to not even mention the other literature. They even said something to the effect of "to get optimal marginal rates at the current level the elasticity would have to be very high, something like 1". Ignoring of course the fact that plenty of research says that's about right. And there's plenty of research saying that one isn't right or wrong, they're just measuring different things. (E.g. Rogerson/Keane 2011, Sargent/Ljungqvist 2011) Using the larger estimates preferred by macroeconomists yields something more like Prescott 2004 or Ohanian/Raffo/Rogerson 2006.

I wonder if our dear friend Noah will call them for their elasticity cherrypicking?

Steve: "Also, the consumption tax does not actually promote savings relative to the income tax, except because people are effectively more risk averse and will self-insure by saving more."

I thought the standard argument was that an income tax, because there's a tax on interest income, raises the price of future consumption relative to current consumption, and so reduces saving, relative to a consumption tax.

The simplest way to implement a consumption tax, either progressive or not, is just to allow unlimited RSP contributions (what's the US version of the Canadian "RSP"? I think it's "401k?).

If it's the tax on interest income that's the problem, we could just get rid of that. Of course there are many other goofy features of the US income tax code, if we want to get started on that.

On the RSP contributions, I don't get it. The current arrangement (indeed 401K in the US) is that you don't pay the income tax on the 401K contribution, but you're going to pay it (presumably at a lower rate) on retirement. If you don't have income tax, what advantage is there from the RSP? You're not paying the tax unless you're consuming, right?

I thought that the tax on interest income *was* the problem, and was why many economists argue for a tax on consumption, rather than income. With a tax on interest income, future consumption has a higher marginal tax rate than present consumption.

If you have an income tax system, plus unlimited RSP/401K contributions, it's formally equivalent to a consumption tax system. But it's a lot easier administratively to do a progressive income tax with unlimited RSP/401k than a progressive consumption tax, for the reasons you describe in your post (the store would need to know your total annual consumption before it could decide your VAT rate).

Just to add: even if your marginal tax rate is the same when you retire, it's still personally advantageous to use an RSP/401K, because your savings inside the RSP/401K compound at the before tax interest rate, rather than the after-tax interest rate.

I don’t think you’ve got Robert Frank’s argument quite right. It’s useful to start with Fred Hirsch’s Social Limits to Growth and the notion of positional goods, i.e., goods that can’t be provided to everyone, such as a degree from an elite college, a home in an exclusive neighborhood, a Matisse painting, etc. Possession of these goods doesn’t depend on a person’s absolute income, but on his income relative to others. That said, wanting your child to attend an elite college doesn’t necessarily arise from envy. Unfortunately, while everyone can’t be above average, a lot of resources are wasted in pursuit of this aim - this is one of Frank’s main points.

The claim that egalitarian views and demands are rooted in envy has been advanced by many conservative thinkers (but also by Nietzsche). By comparison, consider John Rawls’s general conception of justice: “inequalities are just insofar as they work to everyone’s advantage;” or even his special conception: “inequalities are just insofar as they maximize the income of least well off in the long run.” Can the present level of income and wealth inequality be justified according to either of these standards? If you didn’t know your place in the distribution of talents, social advantages, etc., would you prefer the U.S. or the French distribution of income, bearing in mind that if you eliminate the top 1% of income earners in both countries, per capita incomes in France are higher in the U.S.?

You write, “Given mobility within the income distribution, we all care, for selfish reasons, about how the rich are treated, as we all could be rich some day, or our descendants could be rich.” This claim is open to two criticisms: 1) income mobility is actually greater in the more egalitarian countries of Europe than in the U.S.; and 2) Americans have a very exaggerated view of their prospects for being rich “some day” or even for their “descendants” becoming rich (if current mobility patterns persist in the future).

Obviously, the “behavioral elasticity” of high-income earners in response to higher taxes is important even from a Rawlsian point of view. But it’s also important to take account of the benefits that could flow from an increase in the after-tax, after-subsidy income of the less advantaged. First, permit me to make an old-fashioned Keynesian point: if 1% of income recipients are capturing 70% of total income growth, business sales revenue is apt to be lower than it would be under a more egalitarian distribution of income. And, second, less advantaged households will be in a better position to invest in education, training, etc., if they no longer must live paycheck-to-paycheck.

Envy is a small part of the monumental costs of these externalities. The big parts are position, context, and prestige.

Consider the house you grew up in. If it's like most homes of the 1960s and 1970s it had linoleum, carpet, Formica, and fabric. Not wood, tile, granite, and leather. A middle income family of that time thought of these things as high quality. They were proud of them and their house, and got a great deal of enjoyment. But if a middle income family lived in such a house today, linoleum, carpet, Formica, would they think of it as, as high quality? Would they be as proud of it? Would they get as much utility from it?

Would they?

Or would they get far far less, even if they felt no envy at all of others?

Or consider a 1979 Buick Electra that's not restored at all, but still in decent shape with everything working and clean. Would a person living in Honduras, where this would be considered a very nice car, very high quality, get no more pleasure, no more utility, out of this car than would a person living in a nice part of the US where this would be considered a piece of crap?

Is this the world you actually think we live in?

Because if you do I have to wonder what planet you're living on where a big part of the utility of so many items does not depend greatly on the context, the position, and/or the prestige. That's got to be quite a planet where peoples' utility depends solely on the intrinsic benefits of the product, and the context and position don't affect the utility people get at all, or at least not substantially.

And if you don't live on such a planet, I hope you'll think about what the presence of these enormous externalities means, how they greatly affect what kinds of policies maximize the total number of utilis in society, how we might divert enormous amounts of spending that create little intrinsic-benefit utility, but tremendous zero-sum-game positional, context, prestige utility, to products that are predominantly intrinsic-benefit utility like medical research, alternative energy, education, smart social insurance, community recreation,...

Stephen,If their estimated elasticity of taxable income reaches 0.92, diamond and Saez footnoted that the current US top rate would be optimal. If the elasticity numbers move enough, they would have to advocate lower taxes for the super-rich.

Diamond and Saez pass over the issue of optimal taxation of capital income being perhaps zero, or at least low, by referring to administrative issues at the capital-income boundary.

The Nozickian and Kantian moral objection that high taxes treat some people as nothing more that sources of money for others is not addressed.

Nick, Rawls was awake to the power of incentives. He advocated progressive consumption taxes because these taxes taxed what people take out of the common store of goods rather than what he or she contributes. Also not addressed by Diamond and Saez.

Stephen again,One criterion that Diamond and Saez put forward is a tax policy prescription needs to be implementable. To quote:

“That is, the tax policy needs to be socially acceptable and not too complex relative to the modelling of tax administration and individual responses to tax law.

By socially acceptable, we do not mean to limit the choice to currently politically plausible policy options.

Rather, we mean there should not be very strongly held normative views that make such policies seem implausible and inappropriate at pretty much all times.”

Diamond and Saez misses Joe the Plumber, the Reagan revolution and the politics of the modern republican party, the blue dog democrats and Clinton democrats too.

also see http://www.adamsmith.org/blog/tax-and-economy/calculating-the-optimal-progessive-income-tax which uses the diamond and saez analysis to advocate a large cut in the top income tax rate of 50% in the UK.

adding in 13.8% social security taxes and 20% or so VAT, UK's effective top marginal rate is soaking the rich well past anything that diamond and saez would ever defend?

The concept of envy as habitually used in political economy as well as public intellectual debate on economic policy is markedly elusive and ambiguous. It vaguely points at something we all dislike in a person: the inability to grant others who do better their success. However, evidence of this is almost never presented. What is presented is evidence of an interest in relative well-being/welfare/wealth/utility. However, such an interest may arise from innumeral psychological or evaluative source, most of which do not imply the dislikable trait just mentioned.

rawls specifically excluded enevy from social contracting because 1. principles of justice are chosen should not be affected by individual inclinations, which are mere accidents; and

2. background institutions (including equal political liberties and a competitive economy) make it likely that excessive inequalities will not be the rule.

envy poses problems for egalitarian theories of justice because envy sanctions depriving others of goods, even when that would leave untouched or worsen the envious.

also most observers of envy, from Aristotle on, thought that envy is most often felt toward those with whom the subject perceives himself as in competition, so typically, great disparities in well-being are not envied

is there a relevant difference between feeling envious over a just inequality and feeling envious over an unjust inequality?

In respect to Robert Frank and the richness of the rich making the poor fell bad, Nozick said that what really riles the envious among the have-nots of a society is when they are confronted by haves who have clearly earned their status and possessions:

It injures self-esteem and make one feel less worthy to know of someone else who has accomplished more or has risen higher.

Nozick also said proximity is a factor in the creation of envy than desert: Why not me? Why them? One can manage to ignore much more easily the knowledge that someone else has done more if not confronted daily with them at work or in the media.

Knowing that another’s superior ranking along some dimension depended in part upon unearned natural assets does not soften the lost self-esteem.

These considerations made Nozick skeptical of the chances of equalizing self-esteem and reducing envy by equalizing positions along that particular dimension upon which self-esteem is importantly based.

Nozick said that a contraction of options will only increase envy because it will necessarily and inevitably result in fewer socially acceptable ways of demonstrating worth.

With fewer options and less freedom, the perceptions of inequality and of envy are likely to be more, not less, pronounced

These considerations make one somewhat skeptical of the chances of equalizing self-esteem and reducing envy by equalizing positions along that particular dimension upon which self-esteem is importantly based.

Nozick said that a contraction of options (through law, regulation and other government mandates) will only increase envy because it will necessarily and inevitably result in fewer socially acceptable ways of demonstrating worth.

With fewer options and less freedom, the perception of inequality and stirring of envy are likely to be more, not less, pronounced.

Nozick has valid point here: primitive societies were racked with envy and much of the good fortune in those socities were tainted by luck from harvests and disease.

Nozick said we should expand a person’s options through capitalism making it more likely that he will find something that he does well and can base his self-esteem.

A progressive payroll tax (on wages) is a progressive consumption tax. No problem of overstating the worth of assets. Also no hassle filling out tax forms every year. All taxes are withheld--no need to even file (for everyone but the self-employed.)

I'm going to confess to not really following a lot of this, but I did follow all the stuff about Frank. It probably doesn't hurt that Prof. Frank taught my Micro 101 class, so I'm familiar with his ideas, straight from the guy.

I'm skeptical of your analysis of Frank on the face of it because as long as you're talking about rich vs. poor, you're not really getting Frank's point. I understand him as being concerned about all the wasteful, non-utility-maximizing, non-general-welfare generating spending that occurs among the rich.

Frank's point, it seems to me, has much less to do with how poor people feel about rich people (and vice versa), than how rich people feel about very-rich people and sorta-rich people. In Frank's thinking (and I think he's right), rich people barely even think about poor people. They are on another planet. But they do think a LOT about how to signal their superiority to other rich people, and this leads to a lot of wasteful... what's the academic term?

Bling.

Bling is not welfare maximizing.

Speaking of bling, by the way... I spent 6 years working intensively among poor people in Philadelphia. I can tell you that they are INTENSELY aware of rich people, and they waste a ton of money that they could use in better ways trying to come off as a little better off than they are.

There is a lot of wisdom in Frank's worldview, but it's subtle.

At the end of the day, it comes down to this: if people spend $100,000 on a self-winding pocketwatch, are we really using our resources as effectively as we could?

I think Frank likes the idea of a progressive consumption tax because he wants to discourage purchases of $100K pocketwatches. If a person knows they are going to get taxed heftily on their stupid bauble, they might bank it instead and the bank can, in turn, lend it to someone who will (ostensibly) put it to better use.

Someone needs to read Daniel Kahneman’s new book. There are cognitive biases that provide force against the “rational” decisions in this case.

1. Status quo bias and loss aversion will make someone stay in the job market

2. “Why do I want to undertake a costly and risky investment for a very small payoff?” Because humans suffer from overconfidence bias and risk seeking at low probabilities of success. Humans are are also only sensitive to logarithmic changes in their income and even at a 90% marginal rate, log(0.1*x) = log(x) + log(0.1) ~ log(x) for large x.

3. Same as 2. Overconfidence bias and logarithmic sensitivity to income.

4. Affect heuristic will cause humans to move somewhere they like, regardless of a cost-benefit analysis. There is also a tendency to only see the benefits of something you are in favor of rather than the costs. Taken together, the US brand as a place where you can get ahead (even though there is a ~ 0.6 intergenerational wealth correlation) and the land of the free (even though we have a very high percentage of our people in prison) will dominate a decision to move here more than fiddly bits about relative marginal income tax rates.

@Stephen Williamson - no, you do just what I said and Frank says, you tax consumption so that excessive consumption will be discouraged. Like I said, give people a reason to think twice about buying pricey, showy stuff.

Sadly, we're moving in the opposite direction. Pennsylvania is considering a law to remove sales tax from the sale of corporate jets here.

This just looks like Frank doing away with consumption that he personally disapproves of. He's trying to justify a Pigouvian tax to correct the externality he wants to see, by I think it's just paternalism.

"Maybe if I walked into Frank's house and looked around, I could find some crap that he bought that I thought was a waste of resources. What do you want to do? Pass laws against bad taste?"

Again, you misunderstand this Steve. This is about far more than $100,000 watches. When people buy wood and granite they may do so predominantly because they want to have "nice" or "adequate" housing. But if everyone had linoleum, carpet, and Formica like in the 70's, then they would feel like they had "nice" and "adequate" at a fraction of the price, so they would be able to achieve the same number of utils, or close, but at a fraction of the price, a huge savings, a huge efficiency.

With a consumption tax (or really any broad tax well spent, but especially a highly progressive one) you gain these great efficiencies. Less people can now buy granite, or leather, or 300 horsepower cars, when they almost never use more than 150, etc. because of the tax, so they don't raise the definition and cost of "adequate" and "good, nice quality". So less horse power, etc. gives the same number of utils (or close), but in return the tax money can buy a ton more of non-positional goods for society of high utility, like basic medical research, public health, safety, and recreation, alternative energy,…You have thus, exchanged a ton of largely zero-sum-game consumption for a ton of non-positional consumption that creates far more total societal utils.

Steve, I'm sending you a gift, Frank's very short book (paper length), "Falling Behind" (2007). I hope you'll read it. It can really expand your understanding as an economist. It contains a lot of evidence, that there's no time to present here, for human nature and evolution making positional externalities hugely important in societal utility maximization.

"But if everyone had linoleum, carpet, and Formica like in the 70's, then they would feel like they had "nice" and "adequate" at a fraction of the price,..."

Yes, if you have eaten Wonderbread all your life, and then you get some fresh-baked whole grain, it's hard to go back. In 1975, I was perfectly happy with instant coffee. Now I have an Italian espresso machine. Once you see something better, the linoleum is going to look shitty. You think this tells us that I should be paying a tax so I won't buy the espresso machine?

Again, Steve, you miss the point. There are large intrinsic (non-positional) benefits to whole grain bread relative to the increased price. It's much better for your health than Wonder Bread. It makes you less overweight, and makes you feel better and live longer in a number of ways. And espresso may intrinsically taste a lot better – a non-positional source of utility. You're using examples of largely, or predominantly, non-positional goods to argue that there are no significant externalities with positional goods.

With home decor, by contrast, the benefits are predominantly how it looks and feels to you. If it looked and felt to you in 1975 to be beautiful and high quality that's pretty much the whole function. That's the pretty much the only way it can create utils. But if other peoples' purchases now make it no longer create a fraction of the utils it used to, then this is a zero-sum-game destruction of utils that drives people to do the same until we reach an equilibrium where no one gets much more utility from their home décor than they used to, but a huge amount of money was spent.

It's like if some people stand up at a stadium, this initially gives them more utility, but then it drives others to stand up, and then eventually everyone stands up, and on sum, there is then no more utility from standing than from the previous sitting in the stadium, but a big cost has been incurred; everyone is a lot less comfortable. Likewise, evolutionarily, when some elk stags start getting bigger antlers, this is a benefit in utils to them individually. They win more battles for mates. But when everyone else follows suit, the utility benefit disappears completely. No one is better off from this overall, but overall the society of elk is far worse off because it's now far less maneuverable and capable of escaping wolves and other predators. If there were a "tax" on antler length then the society of elk would have much smaller antlers, and the resources this tax raised could instead go into enriching the fields and streams the elk eat and drink at.

And a human tax could be more general, as Frank points out. Marginal income or consumption taxes, especially very progressive ones, hit at the higher marginal goods which tend to be positional-utility heavy, and the proceeds can then go into non-, or little, positional goods of much higher total societal utils.)

Pretty much everything we purchase gives us some intrinsic, or non-positional, utility (that is utility we'd get irrespective of what everyone else does, like better taste and health), and gives us some positional utility (It seems high quality and beautiful, or it positions me to live in the safe neighborhood with the educated people. It doesn't make me feel inadequate. It doesn't make me a lot less capable of attracting the opposite sex.) It is those goods that are heavily positional in their utility creation for a single individual where there is a great deal zero-sum-game activity, where negative externalities are endemic and insidious. This is where a large progressive tax can cost little in intrinsic utils to society overall, in utils period, but the proceeds can create vastly more utils if spent smartly on non-, or little, positional goods like basic medical research, alternative energy, public health and safety,…

Frank cites some research which finds that, beyond a certain threshold level of absolute income, self-ascribed happiness doesn’t increase very much, if at all, with further increases in income (Frank 1999, pp. 68-74).

In Japan, for example, per capita income increased five-fold between 1958 and 1986, but the average level of subjective wellbeing, measured by surveys over this period, hardly changed at all. (Frank 1999, p. 72).

Maybe more leisure and more public goods would have made people happier than higher incomes have.

See Juan Carlos Conesa and Dirk Krueger, On the Optimal Progressivity of the Income Tax Code, 2006, Journal of Monetary Economics, October

• This paper computes the optimal progressivity of the income tax code in a dynamic general equilibrium model with household heterogeneity in which uninsurable labor productivity risk gives rise to a nontrivial income and wealth distribution.

• These beneficial effects of a progressive tax system have to be traded off against the efficiency loss arising from distorting endogenous labor supply and capital accumulation decisions.

• Using a utilitarian steady state social welfare criterion we find that the optimal US income tax is well approximated by a flat tax rate of 17:2% and a fixed deduction of about $9,400.

• The steady state welfare gains from a fundamental tax reform towards this tax system are equivalent to 1.7% higher consumption in each state of the world.

There you have it: the optimal tax rate is either 80% or 17.2%! all praises to the two-handed economist

I think what you are talking about is fashion. For some people it's their clothes that are about fashion, for others it's cars, and for others its their houses or what is in the houses. There's a coordination-game aspect to that, but it's also that we like novelty. I.e. We like novelty but we pursue it in a coordinated fashion. I'm still not seeing anything about this that I think needs to be taxed.

"Entepreneurial activity has to be very elastic with respect to tax rates at the top end. Why would I want to risk my own wealth or that of my close family for a very big payoff with very low probability, if that big payoff is taxed at 73%?"

Because current success suggests future success. And if the success is large enough to overflow all of the lower brackets and reach the top bracket (remembered, this is a progressive system, not a flat system) after expenses (since those are deductible) then the rational response would be to double down on the increased likelihood of future success by reinvesting those profits into growth, transforming them into business expenses, and thus avoiding taxation on them.

While, they serve to weed out people looking to make a short term buck over those investing in long term growth, that is a clear net positive, because it is exactly the latter that we want to encourage anyway, while the former amounts to leaching vitality out of the market.

your argument seems to be that the tax system should correct for the stupidity of those who choose to buy positional goods. in other words, you want to use the tax code to encourage bad behavior. not very compelling.

Sometimes is more than stupidity. There is something about signalling (or, a sociologist might say, "status"). If all my friends use an expensive watch and have a fancy car, by refusing to have those I might be signalling to people that I don't belong to that group. This may have subtle but still real consequences to my social interactions.

The effect might be most visible in the workplace. Not wearing certain clothes or using certain gadgets could give other people in the workplace a misleading idea of where I fit in the hierarchy.

How important this is is an empirical question for which I don't have a clue about the answer.

Envy is a small part of the monumental costs of these externalities. The big parts are position, context, and prestige.

Consider the house you grew up in. If it's like most homes of the 1960s and 1970s it had linoleum, carpet, Formica, and fabric. Not wood, tile, granite, and leather. A middle income family of that time thought of these things as high quality. They were proud of them and their house, and got a great deal of enjoyment. But if a middle income family lived in such a house today, linoleum, carpet, Formica, would they think of it as, as high quality? Would they be as proud of it? Would they get as much utility from it?

Would they?

Or would they get far far less, even if they felt no envy at all of others?

First of all, your comment suggests that envy is not important, but it does not suggest that external habit is not important. In other words, claiming that Steve is completely wrong in that statement is purely semantics.

Second of all, how do you know that the demand for leather and granite is driven by position/prestige? Just because people got along fine in the 1970s without certain things, doesn't present prima facie evidence that they don't need them today. Perhaps there were people in the 1970s who wanted these things, but found them beyond their budget constraint.

It seems to me that you and Frank know what is best for everyone and when we protest you conclude that we are all just too ignorant to understand.

"The United States is highly dependent on highly-skilled labor that migrates here from other countries."

Nonsense. Marginally higher corporate profits are dependent on keeping pay for scientists and engineers low by hiring immigrants. The low pay reduces the number of domestic students interested in those fields, justifying hiring immigrants, etc. The US can easily produce the number of technical people needed if Microsoft et al. adjusted pay and/or offered a significant number of scholarships.

I don't have the data, but I don't think that's true. Here's some anecdotal evidence. In my line of work, the new entrants are almost all foreigners. Economics professors are well-paid, but every year when we go out to recruit fresh PhDs to fill assistant professor slots, maybe 10% at most are Americans. In the last 7 years, our department has hired 15 people at all levels. Their nationalities are:

Now, you could say that's just consistent with your hypothesis that cheap foreign labor is pushing down wages. But typically people are making that argument about low-skilled workers. The argument there is that the relative supplies of low-skilled to high-skilled workers is increasing, so the relative wages of the low-skilled fall. If a lot of immigrants come into the US, and they look the same as the US labor force in terms of skills, this is just a scaling up of the size of the US economy, and it should not change wages at all.

You can't at the same time say that cheap low-skilled Mexican labor is reducing wages, and that cheap high-skilled Canadian labor is reducing wages.

Equality has many dimensions, as David Brooks recently adduced. Increased consumption equality may be a good thing, and certainly squeezes PCT into the current debate, but it's by no means the only reason for PCT. Consumption equality is not at all the same thing as income inequality, at least not at a given point in time. In fact, PCT may have the effect of increasing the latter due to incentive effects.

It's those incentives that attract me to PCT. Taxing income on average reduces work incentives without affecting consumption incentives. Taxing consumption has the opposite effect, increasing work incentives and by increasing costs, reducing consumption. Doing so on a progressive basis matches the likely ability of the most productive to increase their output due to their predilection for living well. Generally saved income is invested, which facilitates the increased output resulting from the increased effort.

Franks' PCT is not a VAT, precisely in that rates vary as a function of total consumption. It can be as regressive (flat) or progressive as desired. Tax rates for yacht buyers could exceed 100% (of the yacht price) if we chose. Such progressivity might discourage purchase of luxury goods, but we call them luxuries because we can do without them...

Point-of-sale collection could be seen as a form of withholding, with the added benefit of taxing the purchase of those who are not under US income tax jurisdiction. Alternatively, total administration costs would be reduced if we dumped point-of-sale and used payroll withholding as we do with today's taxes.

Today's taxpayers are used to having their assets tallied, as they must do to qualify for a loan. The system need not be perfect to be better than today's morass. Note that physical assets would be valued at their purchase price, simplifying matters.

Smoothing consumption is one form of risk aversion, but it empowers another kind - the kind associated with taking risks to increase income through starting a company, moving to take a new job, etc.

"the consumption tax does not actually promote savings relative to the income tax, except because people are effectively more risk averse and will self-insure by saving more."

What could this mean? Deferring consumption in favor of savings seems like an obvious win, given our current state of overleverage. High savings countries can prosper, and their position is inherently more sustainable. Arguably, wealthy countries such as the US should be the ones producing net savings while poor countries dissave. By the time when countries have relatively even living standards, then each country should generally be saving only enough to finance its internal investment, but that's decades off.---On 401K's, the difference is that 401K's provide access only to specific asset classes. PCT eliminates such restrictions.

How can a consumption tax increase saving? As you point out, the saving is deferred consumption. If I consume today, I pay a tax today. If I save and consume in the future, I pay the tax tomorrow. Thus (depending on how you discount, and life cycle issues), it looks like a wash in terms of how I allocate consumption over time. But the distortion has to show up somewhere. It's in labor supply. I can choose not to work, and not get taxed, or I can work and consume and get taxed.

"If a lot of immigrants ... look the same as the US labor force in terms of skills,.. it should not change wages at all. ...You can't at the same time say that cheap low-skilled Mexican labor is reducing wages, and that cheap high-skilled Canadian labor is reducing wages."

I think I can say that, if you let me replace "Canadian" with "Chinese" in the above statement. In that case the immigrant labor force does not look the same as the US labor force in terms of critical language and social/cultural skills,

Imagine that you and I and 1000 guys like us emigrate to a small Chinese city. We can do menial labor, or do high-skill technical work in economics or chemistry in our pidgin Chinese. We can't however, be good salesmen, contractors, lawyers, middle managers, CEOs or other jobs requiring strong cultural awareness and communication skills. We will depress wages in the menial and technical fields, but the only affect we'll have on the salesmen and MBA's is to put money in their pockets by providing cheaper labor.

P.S. The distribution of new faculty by nationality is very interesting - looks like your department is now mostly foreign-born, though mostly US-educated. Looks like this trend will continue, since only 8 or so of the 94 grad students in your department seem to be native-born.

1. How many people are really going to choose unemployment over making a quarter of a million a year?

2 and 3. The thing is business expenses can be deducted from your income, so if you're taxed at a high rate a large business risk will considerably reduce your taxes. So the upside of the risk is smaller as a result of the taxes, but so is the downside.

4. Most engineers do not make enough to fall in the top tax bracket.

The point of raising taxes on the rich in our current economic situation is that it is taxing the money least likely to be spent, and it may be the one thing we can do in this economy to improve the fiscal situation without costing jobs.

"The point of raising taxes on the rich in our current economic situation is that it is taxing the money least likely to be spent, and it may be the one thing we can do in this economy to improve the fiscal situation without costing jobs."

This comment is borderline retarded. What, pray tell, are they going to do with the income they "don't spend"? They're not hoarding real money balances, so it must be going into investment. Schmuck.

Cool blog and the time spent responding is even cooler. Why, though, the use of absolutes/false dichotomies to diss things (e.g. "But the distortion has to show up somewhere. It's in labor supply. I can choose not to work, and not get taxed, or I can work and consume and get taxed.")?

Is constantly using the word "model", serious or otherwise, another rhetorical devise to diss alternative views/borrow some pseudo-science credibility for what remains a "social science"?

And are assertions like "Given mobility within the income distribution, we all care, for selfish reasons, about how the rich are treated, as we all could be rich some day, or our descendants could be rich" no a wee bit of a giveaway as to the author's views of society when trends in actual mobility rates are taken into account (and as such hard to reconcile with the aforementioned "model" chat)?

Ya it's right but i will not say so much because here already are so much scholars to discuss .But inequality and taxation are not simplifying ratios of financial crisis even .We must think about this very deeply .

"They're not hoarding real money balances, so it must be going into investment. "

Correct, they will typically use interest earning forms of savings rather than hoard cash. If they can't do that, that means less money for others' mortgages and credit cards. This is not a concern because the economy is not currently constrained by a lack of money to borrow or invest; in fact we've gotten into trouble because we're scraping the bottom of the barrel for ways to invest that money.

Yeah their assumptions are much worse than yours:All consumers and firms are identical in societyEveryone is a rational, self-interested person only in it for the moneyOnly Ed Prescott, Robert Lucas, etc are economists worth listening to

Have you ever taken a brief pause to consider why the Nordic countries are doing so much better? Or perhaps why Canada is doing so much better than the US? Or maybe why economists such as Joseph Stiglitz and Paul Krugman won Nobel Prizes? Or taken a look at statistics and thought about why real wages have been stagnating since the 80s or are simple mathematical models you manipulate into producing the results you want with many unrealistic assumptions the only thing that matters?